Capital Inadequacy

The Global Financial Crisis displayed just how bad regulators are at dealing with problems. Line up the industries with the most government involvement alongside the industries that struggled most and you get a match. Banking and US housing are at the top of that list.

So which is cause and which is effect?

“Deregulation was the prevailing trend of the last few years, so it must have been the lack of regulations which caused the crisis,” the well educated mainstream reader will exclaim.

Yes, no doubt the world’s parliaments tweaked the rules around. But, as we have argued before, as long as a central authority controls the quantity of money and the interest rate, banking is more regulated than anything else.

Usually it’s the interest rate which gets all the attention. Econ-101 teaches us that the central bank will use the interest rate to control the amount of economic activity. The idea is that a bunch of economists get together and figure out the appropriate interest rate over tea and lamingtons (or variations of those depending on which central bank). Then we all live by that rate in “the great moderation”. No irrational exuberance and no depressing recessions.

Only the great moderation turned into the great bubble and came to an end with a great correction.

In the years before, each time the economy wanted to purge itself of bad investments, those investments were made profitable again by lowered interest rates. Central bankers didn’t know that kicking the can down the road doesn’t solve the problem.

So we have a heavily regulated banking system and those at the top of it made a mistake by holding interest rates too low for too long, causing a boom, which was followed by a bust.

End of story? No.

A similar bunch of regulators, who get less publicity, but arguably have more effect, are meddling with the other foundation of banking – the quantity of money.

Their home is that bastion of responsible banking, Switzerland. Basle to be more exact. And in true global regulatory tradition, the regulations the intellectuals at Basle dreamt up were named Basle. But unlike with the climate change bunch, who have Kyoto, Copenhagen, and the rest, the Basle bunch has stayed put each time their lofty ideals didn’t pan out.

And so when ‘Basle I’ wasn’t enough, they came up with ‘Basle II’. As you and taxpayers around the world may be aware, Basle I and II regulations didn’t stop banks from needing bailouts. So we’re back to Basle for the solution – Basle III. (Getting sick of Basle yet?)

Politicians are particularly fond of the concept “if at first you don’t succeed, try, try again.” Your editor owns a poster that says “Failure… It could be that your sole purpose in life is to serve as a warning to others.” Only one of the two applies here.

We should clarify something…

The Basle regulations, among other things, are capital adequacy requirements for financial institutions. In simple terms, they establish minimum capital requirements for banks. They tell banks how much reserves must be held for when things go bad. Kind of like your parents telling you to eat your vegetables.

Only in the case of Basle II, vegetables were defined as whatever the ratings agencies said was good and wholesome. That’s where the whole thing fell apart. The ratings agencies made a spectacular mess of things. Addison Wiggin, the Executive Publisher of Agora, and 5 Minute Forecast contributor, points out the following:

Last month, a long-running Senate study determined that over 91% of the AAA mortgage-backed securities issued from 2006-2007 have since been downgraded to “junk” – BB or lower.

So now it’s back to the drawing board for Basle III…

Well, actually, “Central bankers reach deal on tougher rules” is already a headline in The Age. The deal has been done. The most concerning aspect of this is that all parties congratulating themselves on this achievement seem to emphasize what Basle III does not achieve. The list is too long to publish here. So it looks like we can brace ourselves for plenty more Basles to come.

For now, it is important to grasp just how important capital adequacy standards are. They control the money supply… sort of. To be more specific, they control the velocity of money. Please don’t go to sleep. This is actually the biggest fraud ever committed.

It goes as follows:

Assume Basel has been simplified to state that 10% reserves must be kept for all deposits. So you deposit $100 into bank A. Their statement looks as follows:

It has your $100 and owes you that amount whenever you want it. To make a profit, the bank makes a loan, but has to keep $10 as a reserve in case you ask for some of your money.

Whoever the loan is given to spends that money and the person who receives it deposits it into their bank.

Bank B then does the same thing with its cash, again keeping 10% in reserves.

Bank C’s accounts look like this:

Pretty soon, the banking system is awash with $900 more than when you deposited your $100. That’s a velocity of money of 10, because you end up with 10 times as much money as you started with.

At a capital adequacy requirement of 4.5%, as in Basle III, you get a velocity of money of 22.22. Which means a $100 deposit gives you $2222.22 in money supply. That is if each dollar is leant out by the banks. Banks usually keep excess reserves, slowing the velocity.

But where does all this money come from? Thin air.

Yes, the government has the much maligned license to print money, but so do banks.

To see how this story goes in a little more of its glory, you can read this article.

Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it.
To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.

Something has been bothering me about the example: Imagine it with gold bars. It still works. No gold bars have been created out of thin air! You could take the banks out of it and get the same result: Person A has 100 gold bars. He/she lends 90 bars to person B and keeps 10 so person B has a liability to person A of 90 bars. Person B then lends 81 bars to person C and keeps 9. Person C lends 72.9 bars to person D…(Ok the bar had to be cut..). I have heard it said before that… Read more »

The Chinese buy up raw material stockpiles, Microsoft wants to keep its emerging world cash in the emerging world even though 75% of its SG&A (expenses) are in the good old USA. So borrow and spend and give it back to shareholders in the crappy USD that you know isn’t worth jack…

Or maybe this is subterfuge and Microsoft are the secret owners of all those AUD swaps from the four pillar banks!

“And so when ‘Basle I’ wasn’t enough, they came up with ‘Basle II’. As you and taxpayers around the world may be aware, Basle I and II regulations didn’t stop banks from needing bailouts. So we’re back to Basle for the solution – Basle III. (Getting sick of Basle yet?)”

Only getting sick of you _spelling it incorrectly+ a dozen times in this article, Nick. You’re an expert on this stuff, remember?!~ ;)

Ok. I’ll repost what I meant to say: I’m not sure the reserve example is correct. It still works if you consider gold bars instead of $s – and they can’t be created by the banks…at least I don’t think so. The example you give is the same without banks involved”: a person A has $100 (or gold bars) and lends person B $90, keeping $10. Person B now has a liability to peson A of $90. Person B then lends Person C $81 and keeps $9. Person C lends person D $72.9 and keeps $8.1. etc. etc. I can’t… Read more »

Peter, what you are talking about is the whole M1/M2/M3 thing that Friedman came up with many years ago.

The Austrian idea is that banks should lend money raised from shareholders, not from deposits. When you lend depositors’ money, you are trying to game the system so that nobody ever takes a loss. This leads to bailouts, central banking, and a perpetually inflationary currency.

“I can’t see how money is being created here.”
Thats right because the only money here is the original $100…in the form of three cash deposits of $10,$9 and $8.10 respectively from Banks A,B and C, plus the remaining $72.90 which Bank C will presumeably now lend, in keeping with the example.
“Did you mean something else?”
I’m sure you did didn’t you Nickolai?
Interesting subject.

Peter, you’re right that money isn’t really being created, an illusion thereof has been created. The problem is that the person who started the chain and put their $100 in bank A is told that they still have $100, but if they try to withdraw it the bank cannot give it to them – they only have $10 of it left! Bank A will try to recall their loan of $90, but it has already been spent by the borrower. The first person thinks they have $100, but they only really have $10. Just like the next person down the… Read more »

Daniel Thanks. I admit that I’m a novice and haven’t done much reading on economic theory. But, how can the banks give me interest on my money (that I deposit with them) if they don’t lend it to someone else? If its just sat in their safe then I might as well buy my own safe. Or perhaps I should be paying the bank the to hold my money securely for me. I guess that is the same principle as owning physical gold in a bullion vault somewhere. But I might prefer the gold….. Taking the thought a bit further,… Read more »

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